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A tax on credit unions, depending on the amount of the tax, might lead to the liquidation of marginal units, or more probably to an agitation for changes in the law which would destroy the essential character of the credit union as it now exists. At present neither the earnings of the credit unions nor the amounts which they set aside as reserves offer any significant revenue potentialities. The growth of the credit union system seems to be at a declining rate. Growth, either in number of units or in the size of the units—there are few economies of size in credit unionsoffers slight prospect of increased revenue in the future. To tax credit unions, therefore, would seem to be rather futile since this would yield little in revenue and might seriously weaken, or even destroy, the institutional expression of a high social ideal.

THE TAXATION OF COOPERATIVES

Fred W. Peel, Jr.

INTRODUCTION

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The outline of topics for the general revenue revision study by the Committee on Ways and Means lists "cooperatives” as one of the special problems in corporate income taxation. It does not indicate how broad the definition of cooperatives is meant to be. Presumably, however, since mutual financial companies and insurance companies are listed separately, the topic is not intended to be broad enough to cover cooperatives in those areas.

This analysis is limited to farm purchasing and marketing cooperatives and consumer purchasing cooperatives. It contains no discussion of the various other types of cooperative organizations, such as rural electric cooperatives, mutual ditch and irrigation companies, mutual telephone companies, cemetery companies, housing cooperatives, and cooperative wholesaling and servicing organizations for nonfarm businesses. The same general principles applicable to the farm and consumer cooperatives frequently will apply to these other types of organizations, but their case for exemption or for special treatment may vary because of their peculiar nature or perhaps because of their relationship to social policies of the Government.

An understanding of the purpose of the cooperatives is desirable to place them in proper perspective for an analysis of what income arises from their operations, when it arises, and the factors appropriate for consideration by Congress in determining its tax policy with respect to them.

Cooperatives are not charitable organizations, and do not pretend to be. Their objective is to improve the material, economic welfare of their members. In some cases, but not invariably, their objective is broad enough also to include the welfare of nonmember patrons.

The benefits to society as a whole from cooperatives (through lower prices, more efficient marketing, etc.) are incidental-just as the social benefits from the operations of ordinary profitmaking corporations are incidental. Cooperatives are designed to operate for the direct benefit of their members (or member and nonmember patrons) in proportion to their patronage.

Suppose a member or other patron markets the products of his business through a cooperative (i.e., a farmer sells his grain or milk through a farm marketing cooperative). It is agreed that the amounts he receives from the cooperative as patronage refunds are to be included in the computation of the gross income from his business. Such patronage refunds are, in effect, additional installments of receipts from the sale of his products. Sometimes the distinction between direct sales receipts from or through a cooperative and patronage refunds by reason of the sales is a very

thin one.

Likewise, where a member or other patron purchases supplies or services from or through a cooperative for use in a business or other income-producing endeavor and deducts the cost of such purchases in computing his taxable income, it is agreed that he should take patronage refunds with respect to such purchases into account in computing his taxable income. These patronage refunds may be picked up as items of gross income or they may reduce the deductions which would otherwise be taken for the cost of the supplies or services purchased. Usually it is immaterial whether such patronage refunds are taken into account as gross income items or as reductions of otherwise allowable deductions.

The foregoing are the only areas of general agreement. They leave unsettled seven basic issues. Three of these issues involve the tax treatment of the members and other patrons. These are the following:

1. The tax treatment of patronage refunds received on purchases of personal, nondeductible items;

2. The question of when patronage refunds on business or other income-producing transactions should be taxed to the members or other patrons;

and 3. Assurance that members and other patrons will report for tax purposes the patronage refunds they receive. The other four issues involve the tax treatment of the cooperatives as entities separate from their members. (Since the cooperatives are virtually all incorporated as separate legal entities whose members are not subject to unlimited liability, presumably there can be no serious dispute as to the power of the Federal Government to tax them as corporations.) These four issues are as follows:

1. Exclusion (or deduction) of patronage refunds paid in computing taxable income of the cooperatives;

2. If exclusion (or deduction) of patronage refunds is allowed, the question of when the exclusion or deduction should be allowed

3. The tax treatment of income from nonpatron sources; and 4. The exemption of cooperatives from the income tax.

PATRONAGE REFUNDS ON PERSONAL TRANSACTIONS

The issue of the tax treatment of patronage refunds on personal transactions arises when purchases are made for personal use, from or through either farm purchasing cooperatives or consumer cooperatives. It is not possible to estimate accurately the extent of cooperative purchasing for personal use. The "Fact Book on Cooperatives," published by the Cooperative League of the U.S.A., estimated that in 1957 there were 1.050 cooperatives for the purchase of household supplies, with 700,000 members and an annual volume of business of $170 million."

In addition, some part of the patronage of the farm purchasing cooperatives is for personal use. The estimated total volume of the supply business of local and regional farm cooperatives in 1956–57 (net after adjusting for duplication as a result of intercooperative business) in those types of supplies in which it is likely that personal use is a material factor is as follows: 2

1“Fact Book on Cooperatives With 1957–58 Developments,” the Cooperative League of the U.S.A., Chicago, Ill. (1959), p. 22.

Million Building materials.

$82 Meat and groceries --

49 Petroleum products---

530

661

Total.--These figures compare with total estimated supply business of local and regional farm cooperatives of about $2,144 million.

Purchases by farmers themselves for personal use do not account for all the personal consumption through farm cooperatives. A survey of 21 major regional farm purchasing cooperatives in 1956–573 shows that most of them had some nonfarmer patronage, and 8.6 percent of their total number of patrons were nonfarmers in 1957.

Some portion of the patronage of the consumer cooperatives and of the nonfarmer patronage of the farm cooperatives probably represents purchases which are deductible expense items in nonfarm businesses.

On the basis of the fragmentary data available, it seems reasonable to assume that the total annual volume of purchases for personal, nonbusiness use through consumer cooperatives and farm cooperatives is probably of the magnitude of $200 million to $300 million. Patronage refunds on these purchases are probably a relatively small percentage of the total volume of purchases.

Patronage refunds received on purchases made from or through a cooperative are analogous to adjustments to the purchase price, or discounts. In some cases these patronage refunds may merely be rebates on prices which were originally set higher than comparable prices charged elsewhere in order to give the cooperative the financial security of a bigger margin on sales.

Such patronage refunds are not a return for services rendered by the patron. The only service required is that he patronize the cooperative. This is no more than the service required of a customer in order to qualify for the lower prices at a clearance sale or at a discount house, and our tax system does not treat the savings resulting from careful shopping as income. Patronage refunds on purchases for personal consumption are similar in this respect to the redemption of trading stamps.

Nor do these patronage refunds ordinarily represent a return on capital. The refunds are proportionate to patronage, not capital investment. In many consumer cooperatives the initial investment by members is relatively minor. In the case of patronage refunds received by nonmember patrons who have no capital investment there can be no question of treating the refunds as return on capital.

It may be argued that patronage refunds are used as a substitute for payments for the use of capital invested by the patrons in a cooperative where a substantial share of the cooperative's capital is pro

2 “Statistics of Farmer Cooperatives, 1956–57," U.S. Department of Agriculture (1959), table 10, p. 17.

3 "Handbook on Major Regional Cooperatives Handling Farm Supplies, 1956 and 1957," by J. Warren Mather, Farmer Cooperative Service, U.S. Department of Agriculture (1959), p. 47.

vided through allocated but retained patronage refunds of past years on which neither interest nor dividends are paid. However, as the subsequent analysis will indicate, these amounts properly should be treated as retained earnings of the cooperative rather than as amounts paid to the patrons and reinvested by them. Under this latter theory patronage refunds received could not be considered a return on investment by the patrons of the allocated but retained patronage refunds.

Neither member nor nonmember patrons should be required to include in gross income patronage refunds received from cooperatives on purchases of personal, nondeductible supplies or services. Such refunds should be accorded the same treatment as price discounts.

Of course, if members of a consumer cooperative or a farm purchasing cooperative receive distributions out of net margins earned by the cooperative on business with nonmember patrons or from other outside sources, such distributions are not patronage refunds, even though allocated in proportion to the members' patronage. Instead, they are corporate dividends, and there does not appear to be any reason why they should not be taxed as such.4

EXCLUSION (OR DEDUCTION) OF PATRONAGE REFUNDS BY COOPERATIVES

Before reaching the question of when patronage refunds are deductible it is necessary to decide whether, in fact, they should be deducted, or excluded, by cooperatives in computing taxable income. The argument is made that a cooperative's net margin on transactions with its patrons, before subtracting patronage dividends, represents earnings by the cooperative and should be taxed to it as such. It is argued that this net margin is income to the cooperative for its services and for the use of its capital. While the result would be double taxation of the patronage refunds (at least in the case of farm marketing cooperatives and patronage refunds paid on business purchases through purchasing cooperatives), this treatment is justified by analogy to the double taxation of corporate dividends paid to stockholders by ordinary corporations.

The cooperatives can control the size of the net margins which are to be distributed as patronage refunds. Marketing cooperatives can reduce such margins by paying higher prices to their patrons in the first instance, and purchasing cooperatives can achieve the same result by charging lower prices to their patrons. This creates a practical difficulty for the proposal that the cooperatives be taxed on their net margins before patronage refunds. It also points up the fact that the net margins which a cooperative is obligated to distribute as patronage refunds are different in kind from corporate earnings distributable as dividends to stockholders.

The argument by analogy to the double taxation of corporate dividends has been weakened by the enactment of subchapter S of the Internal Revenue Code, which permits certain corporations with a limited number of shareholders to elect to have their income taxed directly to the shareholders without an intervening corporate tax.

As was pointed out in the discussion of patronage refunds on personal transactions, patronage refunds are not payments to the patrons for either services or capital. They are not analogous to dividend

I.T. 3208, C.B. 1938-2, p. 127.

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